Investor Bias Favors Real Estate in 2004

Prices of well-occupied real properties and REIT shares have done well during the past two years, despite deteriorating space market conditions. One reason is that real estate assets have provided much better returns than alternative investments. Stock prices suffered huge value declines from 2000 to 2003. Hence, many investors fled out of stocks and bonds into real estate. But in the past few months, stock prices have rallied noticeably.

This raises the question of whether the capital that fled into real estate from non-real-estate stocks will retreat once more. If so, prices of both well-occupied real properties and REIT shares might start falling.

Whether this happens is related to the tendency of investors to adopt “biased” attitudes toward specific asset types, based upon their recent experience. When an asset type suffers a devastating value collapse, most investors become biased for a considerable time against keeping funds in that asset type, or putting more funds into it.

How long such biases persist depends upon a few factors. One is the seriousness of the asset value collapse: the worse it is, the longer investors' bias against it persists. The second is the availability of alternative investments that have not experienced recent value collapses.

Investors Can Be Fickle

In the early 1990s, commercial real estate values plunged, thanks to massive over-building in the late 1980s. Hence, institutional investors became strongly biased against commercial real estate throughout the first half of the 1990s. This bias was reinforced by government regulations against banks and insurance companies funding commercial properties. At the same time, the general stock market began a long upward movement, led by high-tech and Internet stocks. This bull market promised better returns and less risk than recent experiences with real properties had demonstrated. As a result, capital shifted out of real estate and into the stock market, but not into REIT shares.

This bias favoring technology stocks and against commercial real properties persisted through the middle of the decade, although space market conditions markedly improved after 1993. Neither REIT share prices nor commercial property prices moved upward commensurate with improvements in space market conditions because technology and Internet stocks were siphoning off most available investment funds.

This situation changed radically when technology and Internet stock prices collapsed in 2000, dragging most other stocks down with them. Investors were seriously burned. As a result, their biases reversed almost overnight from being pro-stocks and anti-real estate to being anti-stocks and pro-real estate — including pro-REIT shares. That caused a flood of capital into real properties — even though space market conditions were deteriorating.

Factors Favoring Real Estate in 2004

In the past few months, prices of non-real estate stocks have begun recovering from their low points, led by technology stocks. Consequently, some analysts predict that capital will soon begin withdrawing from real estate investments and shifting back into non-real estate stocks.

However, I believe any such withdrawal will occur gradually enough so the prices of both well-occupied properties and REIT shares will not soon experience any sudden or serious downward movements. This prediction is based upon the following seven factors:

Losses in stocks from 2000 to 2002 were so great investors still do not trust a major stock market recovery.

The economy is likely to expand slowly rather than exhibit a dramatic and sustained upward movement, especially in jobs.

Space market fundamentals will improve as the economy expands.

Low interest rates will persist long enough to maintain leveraging as a profitable support under commercial property prices.

Investors will avoid bonds because of low yields, but if bond yields start rising that will mean higher interest rates and lower bond prices.

Technology stock prices have already been bid up to quite high levels.

A desire for significant current income sought by retiring baby boomers will keep demand for REIT shares strong.

Hence, the current bias causing many investors to look favorably upon keeping funds in commercial properties will persist well into 2004 and perhaps longer.

Anthony Downs is a senior fellow at the Brookings Institution in Washington, D.C. He can be reached at anthonydowns@csi.com.